In Bond Frenzy, Investors Bet on Inflation

October 25, 2010

In Bond Frenzy, Investors Bet on Inflation

By CHRISTINE HAUSER

At a time when savers complain that they are earning almost no interest from their bank accounts, some investors on Monday bought United States government bonds that effectively had a negative rate of return.

Bizarre as it sounds, that is correct. In an auction of a special kind of five-year Treasury bond, investors paid $105.50 for every $100 of bonds the government sold — agreeing to pay the government for the privilege of lending it money.

The reason is that these types of bonds offer a guaranteed protection against inflation. So, if inflation soars — as some economists worry might happen, with the government seeking to give the economy a boost by flooding it with money — the value of the bonds would go up accordingly.

The investors who took part in the $10 billion auction are betting that inflation, now at about 1 percent annually, will rise to a level that more than compensates for the premium they paid.

The unusual auction on Monday “reflects a condition in the Treasury market that has been in place for months, chiefly that yields on shorter maturities have moved below the inflation rate,” Anthony Crescenzi, a senior vice president at the bond giant Pimco, wrote in a research note.

Guy LeBas, the chief fixed-income strategist for Janney Montgomery Scott, said there were about $28 billion worth of bids for the notes. About 40 percent were foreign buyers, 57 percent dealers and the rest were possibly retail investors, he said. The prediction is for a 1.58 percent rate of inflation, as measured by the Consumer Price Index.

“It was good demand considering the negative yields,” he said. “They are counting on the Fed to be successful in generating inflation.”

As strange as all this may seem, these investors were actually going along with conventional market wisdom. Many economists are concerned that if the economy continues to stagnate, there is a danger of deflation, or a decline in prices, that would be difficult to reverse.

Most analysts expect that the Federal Reserve, which has already lowered interest rates to near zero and bought Treasury securities in efforts to reinvigorate the economy, is about to pump even more money into the system. Such a move would probably increase the rate of inflation.

Fed officials have hinted at such action in recent appearances. In a speech in Boston on Oct. 15, the Fed chairman, Ben S. Bernanke, said that “there would appear — all else being equal — to be a case for further action.”

The markets interpreted that and other statements as unmistakable signals that the Fed was poised to act at its next meeting, on Nov. 2-3.

Mr. Bernanke couched his argument in terms of the Fed’s mandate to keep prices stable and maximize employment. He said that inflation had been running well below the implicit target of about 2 percent and that unemployment, at 9.6 percent, was too high.

Inflation-protected Treasury securities have already been trading at negative yields on the open market for some time, as professional and institutional investors have sought to hedge their portfolios against the risk of inflation. But Monday was the first time since the government began selling these so-called Treasury Inflation-Protected Securities in the 1990s that new ones were sold at a negative yield.

Buyers “believe we have reached the bottom of the inflation cycle and the next move is higher, not lower,” said Kevin H. Giddis, the executive managing director and president for fixed-income capital markets at Morgan Keegan & Company.

A growing aversion to risk has produced all manner of investment oddities in the last two years. At the height of the financial crisis, for example, the yield on ordinary short-term Treasury bonds turned negative for a brief time as people flocked to safe investments.

Even now, big investors are buying gold at levels unseen in decades, to protect against fluctuations in the value of currencies. Small investors are fleeing the stock market in droves, favoring bonds and even cash over equities. Companies have managed to sell bonds that do not pay off for 50 or even 100 years.

The remarkable auction occurred as stock indexes on Wall Street edged higher, buoyed by recent strong corporate earnings and a month-to-month rise in housing sales.

Sales of previously owned houses increased 10 percent in September from August, to a seasonally adjusted annual rate of 4.53 million units, above forecasts of 4.30 million, but they were still down 19 percent from September 2009. The National Association of Realtors said about a third of the sales last month were related to foreclosures.

On Monday, the Dow Jones industrial average rose 31.49 points, or 0.28 percent, to 11,164.05. The broader Standard & Poor’s 500-stock index gained 2.54 points, or 0.21 percent, to 1,185.62.

The Nasdaq composite index climbed 11.46 points, or 0.46 percent, to 2,490.85.

Bond prices fell, with the yield on the 10-year Treasury rising to 2.56 percent from 2.55 percent late Friday.

As equities advanced, the dollar declined over the weekend after promises by the world’s 20 biggest economies to avoid a currency war.

It was the latest sign that financial markets are positioning for a rise in inflation. Economists point to the fall in the dollar as a sign of budding inflationary pressures. Another is the recent sharp rise in the price of some assets, including commodities like gold.

Graham Bowley and Sewell Chan contributed reporting.

http://www.nytimes.com/2010/10/26/business/26bond.html?ref=business&src=me&pagewanted=print